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Corporate Finance Notes - CFI 2201 A. Mashiri
COURSE OBJECTIVES
COURSE OUTLINE
1. Sources of Finance
4.1. Overview of Financial Markets
4.2. Evaluation of Main Sources of Finance
4.3. Equity Issues, Rights Issues, Retained Issues
4.4. Bond Issues and other debt instruments
4.5. Venture Capital
2. Valuation of Securities
2.1. Bond Valuation
2.2. Bond Yields
2.3. Risks Associated in Investing in Bonds
2.4. Equity Valuation
2.5. Option Valuation
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5. Leasing f Financing
5.1. Dividend Defined
5.2. Types of Leases
5.3. Forms of Lease Financing
5.4. Rational of Leasing
5.5. Accounting and Tax Treatment of Leasing
5.6. Evaluation of leases
5.7. Present value of Lease Contract
5.8. Valuation of Borrowing Alternative
5.9. Importance of the Tax Rate
5.10. Issues in Lease Analysis
5.11. Hire Purchase
Suggested Reading
Brealey, Richard and Meyers, Stewart, Principles of Corporate Finance; 4th ed.
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Pike, Richard and Neale, Bill, (2006) “Corporate Finance and Investment:
Decision and Strategies”, 5th Edition, Prentice Hall
Van Horne, James, Financial Management and Policy, 4th edition, Prentice
Hall International Editions.
Weighting of Assessment
Examination - 70%
Coursework - 30%
1. SOURCES OF FINANCE
1.1. Overview of Financial Markets
This topic identifies the sources of finance namely Debt and Equity capital.
Source of debt and equity is the financial market.
Financial Market is a place through which securities are created and traded.
There are several different types of financial markets:-
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When an asset is bought or sold for future delivery at some date then it
is traded in future market.
NOTE: The issuer of the security does not receive any proceeds from
the sale of the security in a secondary market.
(f). Private & Public Markets
In Private Markets transactions are negotiated directly between two
parties e.g. black market transactions.
Whereas in Public Markets standardised contracts are traded on
organised exchanges e.g. Zimbabwe Stock Exchange.
Secondary Markets
A secondary market is a market in which securities are traded. There are two
main markets to be considered: -
Organised Exchanges
Over the counter markets
Organised Exchanges
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- Stock markets are the most creative and most important secondary markets.
- Stock exchanges operate as auction markets as buyers and sellers are
matched.
- Examples of Stock Exchange
o Zimbabwe Stock Exchange
o New York Stock Exchange
o London Stock Exchange
o Botswana Stock Exchange
o Nairobi Stock Exchange
o Zambia Stock Exchange
NOTE: Stork Exchanges in developing countries are smaller compared to
developed countries.
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The companies selected for those purpose as included in the official trading list.
Certain strict standards must be met and fees paid for initial and continued
listing.
(e). Prestige
- Companies seek listing for prestige reasons meaning you have met
requirements of listing such as fees e.t.c.
- Since the company will be known it becomes easy even to borrow
because you will be known.
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Disadvantages of Listing
(e). Control
Managers will not have control on the day to day running of the business
once the company is listed.
Dual Listing
- A dual listing is whereby a company is listed on more than one stock
exchange.
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De-Listing
It is the process of making a public company private.
De-listing can be volunteering or it can arise because a company has fallen
short of the listing regulations.
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Debt capital
- This can be long term e.g. bonds and debentures or can be short term
e.g. bank overdraft or commercial paper.
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- Long term debt is sourced from banks and other lenders of capital such
as life assurance companies or pension funds e.g. PTC Pension Fund.
- Where a company needs to fill in a short term funding gap it can use
short term debt, e.g. money market which has duration of less than a
year and is found under the current liabilities in Balance Sheet.
Equity Capital
- It is the most common source of financing for most companies and is
normally the first source of capital.
- Investors will inject cash or assets into a business in return for a
shareholding in that company.
- Equity is the permanent source of capital – meaning you do not have to
repay it back as long as the company is in existence.
- It can be raised through rights issue or Private Placements.
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Rights Issue
It provides a way of raising new share capital by means of an offer to existing
shareholders inviting them to subscribe cash for new shares in proportion to
the existing holdings.
For example a right issue on a 1 for 4 basis, (1:4) at $2.80 per share would
mean that a company is inviting its existing shareholders to subscribe for one
new share for every 4 shares that they hold at a price of $2.80 per share.
Retained earnings
- These are profits that are not paid out as dividends but are retained in
the company.
- Retained profits are an attractive source of finance because investment
projects can be undertaken without involving the shareholders or any
outsiders.
- Use of retained earnings as opposed to new shares or debentures
avoids issuing costs.
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Start up Capital
Launch
Launch Stage
- The pre-launch stage of a business a company will require seed capital.
- If the product still appears financially viable after these initial investments
the additional expenditure can be made for operating facilities e.g.
operating equipment then start up capital will then be required.
Start-up Business
Note: The start-up stage for a company represents highest level of business
(Which is risk associated with business itself e.g. high fixed costs, price
controls e.t.c.
- A start up business is likely to make accounting losses or very nominal
profits; for this reason start-up business should be financed by equity.
Moreover start-up companies have a large and growing demand for
cashflow, therefore taking on debts will put pressure on its cashflows.
- In the launch stage the very high business risk implies that cost should be
kept variable and long term financial commitments should be avoided.
- Financing start-up business should come from:
o Business Angels
o Venture Capitalist
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Business Angels
- These are individuals that have made money in their own enterprises and
are seeking the excitement in the financial reward of investing in another
business.
- The Angels usually receive stock / shares and a seat on the Board of
Directors.
- As individuals are involved the deal is quicker to close and the
documentation much simpler.
- They have a very flexible approach and their analysis less vigorous.
- However they can only invest much lower amounts that Venture Capitalists.
Venture Capitalists
- These are normally professional investors who specialise in a particular
industry.
- They have a short term investment horizon.
- Their focus is to invest during the high risk start up phase of business
which if it is successful they can realise capital gains.
- They expect high rate of returns on their investment portfolio.
- As the total risk of a company declines over its transition from launch to
growth stage, the returns on new capital will fall, and hence venture
capitalists will no longer be interested in financing further operations. They
want to exit at this point and invest the proceeds in further high risk
investments
NB: Example of Venture Capitalists is Takura Ventures
Corporate Ventures:
- Corporate Venturing Companies invest in promising new ventures in order
to exploit their ideas to obtain the benefits of their new technology and gain
on urge on the market.
Growth Stage
- In the growth stage sales start to increase significantly as the product
attains market acceptance.
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- Although business risk is still high it has been reduced from that of the
launch stage.
- There may be additional funding requirements. A new equity has to be
identified to replace original venture capital and provide continued capital.
- Initial public offerings are common at this stage and provide an exit route
for venture capitalists.
- Attracting equity investors is not a problem at this stage as prospects for
future growth are high.
- The cash generated by the business is for re-investments and no dividend
is paid.
- Investors look to capital gains as a major source of capital.
Maturity Stage
- At this stage in the life cycle product demand and supply are now
synchronized.
- Replacement demand becomes major source of total sales.
- Cash flows are positive and there is a reduction in business risk.
- There is reduction in business risk which enables financial risk to be
introduced through borrowing.
- Because the cash flow are positive this enables the company to service
interest and principle repayment.
- The company can also afford to pay dividends.
Decline Stage
- At this stage demand for the product will eventually start to fall.
- Business risk is low at this stage and using more debt can increase the
financial risk.
- Re-investment into the business is no longer priority as the future growth
prospects are negative.
- Companies can now instigate a high dividend pay off policy.
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Characteristics of Bonds:
1. Par Value / face value
- It is the stated face value of the bond. This is the amount paid to the
bond holder on the maturity of the bond.
- The par value represents the amount the issuer borrows and promises
to repay on the maturity date.
2. Coupon Rate
- It is the annual and semi-annual or quarterly interest payment paid to
investors.
- It may be fixed or floating. Some bonds do not pay coupons at all.
3. Yield
- It is the required rate of return on the bond. It is the rate of interest
required by investors in order to entice them to invest in a bond.
- They yield changes with changes in interest rates in the economy and
credit worthiness of the issuer.
4. Maturity
- Bonds have specific maturity dates on which the par value must be
repaid.
- The effective maturity of a bond declines each year after it has been
issued.
Bonds Classification
1. Coupon Payments
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NOTE: - It is important to know the issuer so that one can asses the risk
involved under the bond being issued.
4. Priority
- The priority of the bond determines the probability that the issuer will
pay you back your money.
- The priority indicates your place in line should a company defaults in
payments.
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5. Currency
(a). Domestic Bonds.
These are bonds issued by the domestic borrower in their own
national markets denominated in the local currency that can be
purchased by anyone in possession of that currency.
(b). Foreign Bonds.
These are bonds issued by the national markets by foreign
companies or government in the currency of that country in which
the market is based.
Examples:
* Bonds issued pound sterling in London by foreigners are called
“Bulldog Bonds”
* Similarly bonds issued in US$ denominations in New York by a
foreigner are called “Yankee Bonds”
* Bonds issued in Japan by foreigners in Yen denominations are
called “Samurai Bonds”
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Bond
Price
Yield
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- However a change in the level of interest rates does not affect all
bonds in the same way.
- In order to determine how sensitive a bond price is to change in
interest rates one has to know the price yield relationship.
- The Price Yield Curve is a plot of the bonds required rate of return to
its corresponding price.
- It is not a straight line, it’s a convex.
(a) Long Term Bonds - These are more price sensitive to a given
change in yields than the short term bonds.
(b) High Coupon Bonds - These are less price sensitive to a given
change in yields as compared to lower coupon bonds.
(c) Premium
If the bond price is higher than its par value the bond will sell at a
premium – its coupon rate is higher than the required yield or
prevailing rates.
That is Coupon rate 〉 yield
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(d) Discount
If the bond price is lower than its par value the bond will sell at a
discount – the reason being coupon rate will be lower than the yield.
(e) Par
This means the interest rate of the bond equals the prevailing rate.
If the coupon rate on the bond equals the prevailing interest rates
the bonds trades at par.
That is Coupon rate = yield
2. VALUATION OF SECURITIES
C C C M
Bond Price = + + ...... +
(1 + i ) (+1) 2 (1 + i ) n (1 + i ) n
1
1 −
n
(1 + i ) M
= Cx +
i (1 + i ) n
Where:-
C = Coupon Payment
n = number of payments
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For Interest payment paid more than once a year we effect the formulae
below
1
1 −
(1 + i ) n × f
C f M
Bond Price = x +
f i i
(1 + ) n × f
f f
Where:-
f = frequency
Assume that coupon payments are made semi-annual to bond holders and
that the next coupon payment is expected in 6 months.
Solution:
1
1 −
(1 + i ) n × f
C f M
Bond Price = x +
f i i
(1 + ) n × f
f f
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1
1 −
(1 + 0 ,12 10 × 2
)
100 2 1000
= x +
2 0,12 12 × 2
0,12
2 1 +
2
= 50 x
[0,688195 273] + 311,80472
0,06
= 573,50 + 311,80
= 885,30
Example 2:
25 years ago ZESA issued an annual coupon payment bond with a 10%
coupon rate and a $1,000 par value.
The bond has now 10 years remaining until maturity.
Due to the change in the interest rates and market conditions the required
rate of return on the Bond is 8%.
Solution:
1
1 −
(1 + i )
n
M
Intrinsic Value = C× +
i (1 + i ) n
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1
1 −
(1 + 0,08)
10
1,000
= 100 × +
0,08 (1 + 0,08)10
= 100 ×
[1 − 0,463193488] + 463,193488
0,08
= 100 ×
[0,536806512] + 463,193488
0,08
= 671,01 + 463,193488
= $1,134.20
M
Bond Price =
(1 + i )n
Where:-
n = number of payments
Example:
Solution:
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M M
Bond Price = Bond Price =
n× f
(1 + i )n i
1 +
f
1, 000 1, 000
= =
5× 2
(1 + 0,06)5 0,06
1 +
2
1, 000 1, 000
= =
(1,06)5 (1,03)10
= $747,26 = $744,09
Example:
Solution:
M
Bond Price =
(1 + i )n
1, 000
=
(1 + 0,094)15
1, 000
=
(1,094)15
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= $259.86
C
Bond Price =
i
Where:-
C = Coupon Payment
Example:
Calculate the amount investors will be willing to pay for such a debenture in
2004 if the prevailing interest rate is 11%.
Solution:
C
Bond Price =
i
100 × 8%
=
100%
0,08
=
0,11
= $72,73
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The three sources of return that may compromise a yield on a bond at:-
Ö Periodic Coupon Interest.
Ö Capital gains – resulting from buying at a different price then the one
received when the security is sold / matures.
Ö Re-investment Income – from investing periodic cashflows.
1. Current Yield
Coupon payment
It is the
Current price of Bond
Coupon
=
Market price
Example:
Solution:
Coupon
Current Yield =
Market price
7% of 1,000
=
1,100
70
=
1,100
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= 6,36%
Current yield is used to estimate the cost of profit from holding a bond.
Example: - if other short term interest rates are higher than the current
yields, the bond is said to carry a running cost or negative carry.
(a). The current yield does not take into account potential gains or losses
resulting from the difference between the current market price of a
bond and its value upon maturity.
(b). It does not take into account time value for money.
P − PB
C+ v
Year to maturity =
n
1
(Pv + PB )
2
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Where:-
C = Coupon
Pv = Par Value
NB: Usually YTM is not given but bond price will be given.
The YTM is calculated by iteration. It is the discount rate that equates the
present value of all the bonds expected cashflows with the current market
price of a bond.
Example:
Solution:
P − PB
C+ v
Year to maturity =
n
1
(Pv + PB )
2
100 − 96.50
8,75 +
= 1
1
(100 + 96.50)
2
= 12,47%
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(a). It takes into account the potential gains or losses associated with
holding the bond to maturity.
(b). It takes into account that coupon receipts can be re-invested and
hence further interest rates.
(c). The YTM assumes a flat yield curve meaning that it assumes all
interest rates will stay the same through out the period and that
coupons are re-invested at that constant rate.
3. Yield to Call
Callable bonds might not reach maturity for the very reason that they
may be called before maturity.
Hence that yield to call was developed to measure the return on a bond
if it where to be called on a particular call date.
Formulae
P − PCB
C + Call
Yield to Call =
nc
1
(PCall + PCB )
2
Where:-
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trading currently)
nc = Number of periods until the call ends.
Example:
What is the YTC of a 6% coupon, 5 year bond priced at $98 that is
callable in 3 years at $105?
Solution:
P − PCB
C + Call
Yield to Call =
nc
1
(PCall + PCB )
2
105 − 98
6+
=
3
1
(105 + 98)
2
7
6+
=
3
101,50
= 8,21
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(b). It assumes that the interest received from the bond will be re-invested
at the yield to call rate.
2. Call Risk
This is the risk that a bond will be paid off before its maturity date.
3. Re-investment Risk
This is the risk that cashflows or income generated might have to be re-
invested at lower yields if interest rate falls.
4. Default Risk
This is the risk that the issuer will fail to make interest for principal
payments when they fall due.
6. Liquidity Risk
This is the risk that the bond will not be sold so quickly because the
market is in liquid.
7. Re-structuring Risk
This is a risk that arises from the potential conflict of interest between
different claimants on firm’s assets when a company restructures.
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9. Inflation Risk
When inflation increases value of the bonds decreases.
(b). Income
Ordinary Shareholders are entitled to a dividend but a company and its
directors are under no obligation to declare a dividend.
(c). Priority
In the event of a company being liquidated ordinary shareholders’ stand
last in the line to receive proceeds of liquidation as they are the residual
owners of the business. All other shareholders have to be paid before
they can receive their proceeds.
(d). Maturity
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D1
P0 =
Ks
Where:
P0 = The value of Ordinary Share
Example
Edgars expects to pay a dividend of $3.60 at the end of each year
indefinitely into the future.
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If investors require 12% rate of return, what is the intrinsic value the
ordinary shares at Edgars.
Solution
D1
P0 =
Ks
3,60
=
0,12
= $30.00
D0 (1 + g + )
P0 =
Ks − g
Where:
g = Growth Rate
Example
Kingdom Bank has just paid a $2 dividend. Analysts expect the firm’s
dividend to grow at a constant rate of 6% per annum.
Solution
D0 (1 + g + )
P0 =
Ks − g
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2(1 + 0,06)
=
0,14 − 0,06
= 26,5
D (1 + g1 )t Pn
P0 = +
(1 + K s )t (1 + K s )n
Where:
D0 = Dividends that has just been paid in period zero
n =
t = Length of the supermodel growth period
D (n + 1)
Pn =
(K s − g 2 )
Example:
Analysts expect dividend of Econet wireless to grow at a rate of 20% for
the next 4 years and at a rate of 5% there after.
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Solution:
Step 1:
Find the present value of the dividend during the supernormal growth
period.
D0 + (1 + g1 )t
=
(1 + K s )t
2 (1 + 0,20 )1 2 (1 + 0,20)2 2 (1 + 0,20 )3 2 (1 + 0,20 )4
= + + +
(1 + 0,12)1 (1 + 0,12)2 (1 + 0,12)3 (1 + 0,12)4
= 2,142857143 + 2,295918367 + 2,459912536 + 2,63565300
= 9,534
Step 2:
Find the present value of the terminal price at the end of the
supernormal growth period.
Note: Pn = P4
D (n + 1)
Pn =
(K s − g 2 )
D (n + 1)
P4 =
(K s − g 2 )
4,15 (1 + 0,05)
=
0,12 − 0,05
= 62,25
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Pn
=
(1 + K s )n
62,25
=
(1 + 0,12)4
= 39,56
Step 3:
Sum the present value of both the dividend during the 4 year
supernormal growth period and the terminal price in year 4.
= 9,534 + 39,56
= 49,09
Example:
Cealsys is experiencing a period of rapid growth. Earnings and dividends
are expected to grow at a rate of 15% during the next two years at 13% in
the 3rd year and a constant growth rate of 6% there after.
The company’s last dividend was $1.15 and the required rate of return on
stock is 12%.
Solution:
D (1 + g1 )t Pn
P0 = +
(1 + K s )t (1 + K s )n
Step 1:
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Find the present value of the dividend during the supernormal growth
period.
D0 + (1 + g1 )t
=
(1 + K s )t
= 3,615
Step 2:
Find the present value of the terminal price at the end of the supernormal
growth period.
Pn
Note: =
(1 + K s )n
D (n + 1)
Pn =
(K s − g 2 )
1,7176 (1 + 0,06 )
=
0,12 − 0,05
= 30.34
Pn
=
(1 + K s )n
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30,34
=
(1 + 0,12)3
= 21,59
Step 3:
Sum the present value of both the dividend during the 4 year supernormal
growth period and the terminal price in year 4.
= 21,59 + 3,62
= 25,21
Preference Shares
- These are hybrid securities in that they have some characteristics of
debt & equity.
- Preference shares promise a fixed dividend and in this way they can
be likened to debt.
- However unlike debt preferred dividends are not deductable for tax
purposes. Hence it has a higher cost of capital than debt.
- Almost all preferred stocks have a cumulative feature providing for
unpaid dividends in any one year to be carried forward.
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Dp = Dividend
Example:
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Suppose Delta Corporation has a $100 par value preferred stock that
pays an annual dividend of $7. If investors require an 8% return on this
stock, what will be the intrinsic value?
Solution:
Dp
Value of Preferred Stock =
Kp
7
=
0,08
= 87,50
Example:
Assume the current market price of Schweppes preferred stock is $85 with
a dividend of $7.
What will be the expected rate of return if investors require rate of return of
8%. Should the investor consider buying the preferred stocks?
Solution:
Dp
Value of Preferred Stock =
Kp
7
85 =
x
7
x =
85
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= 0,0823
The investor can consider buying the shares as the Rate of Return is
higher than what they expect.
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Definition of Option
- It is the contract that gives the holder the right but not the obligation to
buy or sell an asset at a pre-determined price known as the strike price
or exercise price on or before some expiration date.
- Most options are American meaning that they can be exercised at any
time before or on the expiry date.
- European Options allow only exercising on the expiry date.
- Example – Puttable Bonds
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NOTE: These are used to limit one’s risk / loss. The righter of the put
thinks the market will go down.
Formulae:
Call Option:
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C = S−K
Put Option:
P = K−S
Where:-
S = Current Stock Price
K = Exercised Price
Ö In the Money
Describes the option where exercise would be profitable.
Ö At the Money
Describes the situation where the asset price and exercise price are
equal.
(c). Time premium
This is a function of the probability that the option could change in
value by the time it expires.
Example:
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The option is to expire on April 15 2004. Until the expiration day the
purchaser of the call is entitled to buy shares for Motorola for $90.
On December 16, 2003 the Motorola stock is trading / selling at $89, 25.
(b) Calculate the intrinsic value if Motorola trades for $100 on the
expiration date and the profits that will accumulate to the investor.
= 89,25 − 90
= − 0,75
= 100 − 90
= 10
Therefore Intrinsic Value = 10
= 10 − 7
= $3
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Example:
In April 2004 maturity Put Option on Motorola with an exercise price of $90
per share, sales on 16 December 2003 for $7.
It entitles the owner to sell the shares of Motorola for $90 at any time until
15 April 2004.
If on December 16, 2003 the Motorola stock is trading / selling at $89, 25.
(b) Calculate the pay off on the expiration date if the Motorola Stock
trades at $80
= 90 − 89,25
= 0,75
= 90 − 80
= 10
Therefore Intrinsic Value = 10
= 10 − 7,50
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Profit = $2.75
Debt, Preferred Stock and Common Equity are the capital components of
the firm. If a company decides to increase its total assets then that increase
will be financed by an increase in one or more of these capital components.
1. Cost of Debt ( K d )
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Formulae:
Cost of debt ( K d ) = Kd (1 − t )
Where t = Marginal Cost of Debt (marginal firm’s tax rate
Example:
Edgars is planning to issue new debt at an interest rate of 8%. Edgars is in
the 40% marginal tax rate.
Solution:
Cost of debt ( K d ) = Kd (1 − t )
= 0,08 (1 − 0,4)
= 0,08 × 0,6
= 4.8%
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Ks = (
R f + Rm − R f β )
Where:
Rf = Risk Free Rate of Return
Solution:
Ks = bond yield + risk premium approach
= 8% + 5%
= 13%
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g = Growth Rate
Example:
Suppose the Edgars Share sells for $21 and next year dividend is
expected to be $1.
Solution:
D1 D1
Po = or Ks = +g
Ks − g P0
D1
Ks = +g
P0
1
= + 0,072
21
= 0,1196
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= 11,96%
Formulae:
D1
Ke = +g
P0 (1 − f )
Where:-
Ke = Cost of Newly Issued Equity
f = Floatation Cost
g = Growth Rate
Example:
Suppose the Edgars Share sells for $21 and next year dividend is
expected to be $1.
Edgars has a return on equity (ROE) of 12% and they are expected
to pay out 40% of their earnings.
Solution:
Formulae:
D1
Ke = +g
P0 (1 − f )
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1
= + 0,072
2 (1 − 0,1)
= 0,1249
= 12,5%
WACC = W d × K d (1 − t ) + W ce × K e + W ps × K ps
Where:
Wd = Weight of Debt
Kd = Cost of Debt
Example:
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Solution:
From previous example the following has been established:
K d (1 − t ) = 4, 8%
Ke = 12, 5%
K ps = 8, 42%
Wd = 45%
Kd = 50%
W ps = 5%
Next step is to substitute these figures into the formulae below and the
weights are established from the given example.
WACC = W d × K d (1 − t ) + W ce × K e + W ps × K ps
= 0,08831
= 8,83%
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This is the perceived risk market in stocks along with the investor’s
inversion to risk. Individual firms have no control over this factor but
it affects the cost of equity.
3. Tax Rates
Companies have no control over tax rates or tax bands.
2. Dividend Policy
The higher the pay-up ratio of a firm then the more it will have to
resort to expensive common stock financing – similarly the more
a company retains the more it can rely on retained earnings.
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3. Investment Policy –
Example:
Hunyani has the following Capital Structure:-
Debt - 25%
Preferred Stock - 15%
Common Stock - 60%
Hunyani’s tax rate is 40% and investors expect earnings and dividends to
grow at a constant rate of 9% in the future.
Hunyani paid a dividend of $3.60 per share last year and its share price
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Required:
Find the company’s cost of debt, preferred stock and common stock.
Assume that Hunyani does not have to issue any additional shares of
common stock. What is the WACC?
- This topic of capital structure serves to see how the capital structure of
a company will affect the company’s risk and how companies should
finance their operations.
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- If the company’s current debt ratio should fall below the target
level, issuing new debt will satisfy the new capital.
- If the firm’s current debt ratio increases above the target level, the
company will be required to raise new capital by retaining earnings
or issuing new equity.
- The use of debt increases risk to shareholders and the higher the
risk associated with the use of debt will depress share prices.
- The firm’s optimum capital structure is the one that balance the
influence of risk and return and maximises the firm share prices.
Cost
K2
Lowest level
of WACC WACC
Kd
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Leverage
Value
Share Price
- Cost of equity increases with increasing debt but more rapidly than
the cost of debt, the increase is to compensate for the risk taking.
- Cost of debt remains low due to the tax shield but slowly increases
as the company increases the gearing to compensate lenders for
the increasing risk
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The more variable a firm’s sales are the higher the business risk.
- Ability to adjust output prices for changes in input prices e.g. those
who sale controlled goods.
- Operating Leverage
The higher the % of the firm’s costs that are fixed then the greater
the business risk.
Tax Position
- The reason why companies use debt is because of the tax deductibility
of interest payments
- The deductibility of interest lowers the effective cost of using debt.
- However if a company is already in a low tax bracket because its
income is sheltered fro taxes by depreciation, interest on current debt
or a tax loss may carry forward, then the use of additional debt will not
be advantageous.
Financial Flexibility
Reasons why you require the capital for will determine whether you get long
term or short term debts.
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- Conservative managers are not risk takers, they would not want to
increase risk, and they would rather opt to borrow shareholders.
They argued that in a world with no taxes companies can not benefit from
leverage or debt financing.
1. Assumption Made
(a) Perfect capital markets – no taxes, all investors
(c) Business risk can be measured by EBIT and firms within the same
degree of risk are said to be in a homogeneous risk class.
(g) The debt of companies and investors is risk free and so the interest
rate on all debt is the risk free rate of return.
(h) All cash flows are perpetuities meaning all companies have zero
growth.
EBIT EBIT
V = =
K su WACC
Where:-
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Vu = Vl
Where:
Vu = Value of an ungeared / unlevered firm
Example:
Two companies Unilever & Longman are identical in every respect
except that Unilever is unlevered whilst Longman has $15 million of
15% debt outstanding.
Solution:
EBIT
V =
K su
12
=
0,3
= $40 million
Vl = Vu
- According to their proposition in the world of no taxes, the value of
a firm is independent of its leverage.
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K SL = K su + Risk premium
= K su + ( K su − K d ) D
S
Where:
K SL = Cost of equity for levered firm
Kd = Cost of debt
Example:
Two companies Unilever & Longman are identical in every respect
except that Unilever is unlevered whilst Longman has $15 million of
15% debt outstanding.
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Solution:
Cost of Debt:
The cost of debt has two parts: -
- It has the explicit cost that’s represented by the interest rates.
- The implicit or hidden cost which is represented by an increase in
the cost of equity which increases when the proportion of debt to
equity increases.
Example:
Two companies Unilever & Longman are identical in every respect
except that Unilever is unlevered whilst Longman has $15 million of
15% debt outstanding.
Assume that all the M & M assumptions hold, there is no corporate or
personal taxes. The EBIT is $12 million for each company.
Calculate the value of Longman taking into account that it had debt in
its capital.
Solution:
Calculating value of Longman equity:
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EBIT − KdD
VL =
K SL
12 − (0,15 x 15)
=
0,39
= $25 million
M & M argued that the total value of these firms has to be the same
otherwise arbitrage will enter the market and derives the values of these
two companies together.
Example:
Two companies Unilever & Longman are identical in every respect
except that Unilever is unlevered whilst Longman has $15 million of
15% debt outstanding.
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Solution:
EBIT
V =
WACC
12
40 =
WACC
12
WACC =
40
= 0,30
VL = V u + TD
Where: -
TD = Tax shield
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EBIT (1 − T )
Vu =
K su
Example:
Suppose both companies are now subject to a 40% tax in their
earnings but all the facts in the previous section still apply.
Solution:
EBIT (1 − T )
Vu =
K su
0,12 (1 − 0,40)
=
0,30
= 0,24
= 24%
Value of levered firm:-
VL = Vu + TD
= 24 + (0,4 × 15m )
= 24 + 6
= 30%
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Example:
(i) What is the cost of equity for Longman?
Solution to (i):
Note that S = (30 – 15 (being cost of debt)
D
K SL = K SU + ( K SU − Kd )(1 − t )
S
15
K SL = 0,30 + (0,30 − 0,15) (1 − 0.40)
15
= 0,30 + (0,15) (0,60 ) 1
= 0,39
= 39% - Cost of Equity.
Solution to (ii):
19 15
= 0,39 × + 0,15 (1 − 0,40) ×
30 30
= 0,24
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= 24%
The theory states that there is an optimum debt ration that maximises the
market value off-setting the benefits of a tax shield against the increasing
cost of financial distress.
1. Definition
Financial distress occurs when a firm has debts. The greater the debts
financing the larger the fixed interest charges and the higher will be the
probability that the company will experience a decline in earnings
leading to financial distress.
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The implication or the signal is that most profitable firms borrow less
because they have sufficient internal funds.
Equity will be used last because according to the signaling theory the
implications of issuing equity is that management perceives trouble for
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Example 1:
Mambo industries has six million ordinary shares outstanding with current market
value of $1 per share.
The company also has debt with current market value of $4 million and a current
interest rate of 12%.
The market has annual earnings before interest of $3 million.
The market believes that this performance can be maintained indefinitely.
The company has a policy of distributing all its after tax earnings as a dividend
and corporate tax is 33%
Required:
(a) Calculate the required rate of return of shareholders in Mambo PLC.
(b) Determine the company’s Weighted Average Cost of Capital.
(c) Use your estimated WACC figure to verify that the total market value of
Mambo PLC is equal to $10 million.
Solution to Example 1:
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EBIT
V =
KSU
EBIT
KSU =
V
3
=
10 6 ordinary shares + 4 Debt
= 30%
EBIT
WACC =
V
3
=
10 6 ordinary shares + 4 Debt
= 30%
(c) Verifying that the total market value of Mambo PLC is equal to $10 million.
EBIT
V =
WACC
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EBIT
KSU =
V
3
10 =
0,30
10 = 10
Example 2
A company is planning a $50 million expansion. The expansion is to be financed
by selling $20 million in new debt and $30 million in new common stock.
The before Tax required return on debt is 9% and 14% on Equity. The company
has a target capital structure of 40% Debt and 60% Equity. The company also has
bonds in issue that pay a 10% semi-annual coupon maturing in 20 years and at
currently trading at $849.54.
The company has a constant growth firm that has just paid the dividend of $2 and
sales for $27 per share and has a growth rate of 890.
Solution to Example 2
Cost of Debt = Kd (1 − t )
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= 0,09 (1 − 0,40)
= 5,4%
D1
Ke = +g
P0 (1)
2
= + 0,08
27(1)
= 15,41%
Therefore:-
WACC = W d × Kd (1 − t ) + Wk e × K e
= 0,0216 + 0,09246
= 0,1141
= 11,41%
1. Introduction
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Company A
Amount
Per 4
Share
3 Earnings per
Share
2
Dividends per
Share
1
Time
Company B
Amount
Per 4
Share
3 Earnings per
Share
2 Dividend per
Share
Time
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In the long run the amount of dividends the companies would have paid
is equal. However the market price of company B may be well above
that of company A. This is due to the fact that investors value dividend
stability and hence will place their trust in company B, and will be
prepared to pay a premium for the share due to the stability of its
dividend. On the other hand, investors prefer a stable dividend as
compared to the one that fluctuates.
Thus:
D1 – D0 = Adjustment rate x Target change
= Adjustment rate x (Target ratio x EPS1 – D0).
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Another legal rule is the undue retention of earnings rule. This rule
prohibits the company from retention of earnings significantly in excess
of the present and future investment needs of the company.
(f) Liquidity
The greater the cash position and overall liquidity of the company, the
greater is its ability to pay a dividend. Cash dividends can only be paid
with cash hence a shortage of cash in the bank can restrict dividend
payments.
(i) Control
Shareholders may prefer that the company pay a low dividend payout
and retain some earnings to finance future investment shares instead of
issuing shares to new stakeholders. Should old shareholders fail to
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take-up new stock leading to new shareholders coming in, their control
will be diluted. From another angle companies in danger of being
acquired may establish a high dividend payout in order to please
shareholders and hence avoid a takeover.
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- The second reason cited is that taxes are not paid on the capital
gains until a stock is sold whereas dividend income will result in an
annual tax liability. Hence this tax liability is deferred which is
advantageous to the investor in that a dollar of taxes paid in the
future has a lower effective cost than a dollar paid today.
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In case of old stock all funds to be reinvested are transferred to a bank that
acts as a trustee. The bank then purchases shares of the company’s
common stock in the open market with either the company or investor
bearing brokerage costs.
The other method is when the firm issues new stock and this is when the
firm actually raises new capital. This method effectively reduces cash
dividends. The company does not pay brokerage costs as the stock is
coming from itself. Normally investors buy the stock at a discount of the
market price. Even though reinvested, the dividend is taxable to the
shareholder as ordinary income, and this posse as a major disadvantage to
taxable investors.
BEFORE AFTER
Par Value $5 $5
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BEFORE AFTER
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Except in accounting treatment, then, the stock dividend and split are
very similar. A stock split, like a large percentage stock dividend, is
usually reserved for occasions where the company wishes to achieve a
substantial reduction in the market price per share of common stock,
thereby at times attracting more buyers. Whilst the dividend per share
falls the effective dividend usually increases, e.g. if the dividend was $2
per share it will be reduced to $1.20 per share.
Reverse stock splits are employed to increase the market price per
share when the stock is considered to be selling at too low a price. The
informative effect in this case is negative, as it might appear as if the
company is in financial difficulties. On the other hand, it might be driven
by the need to move the stock price into a higher trading range where
total trading costs and servicing expenses are low.
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It is the purchase (buyback) of stock by the issuing firm, either in the open
(secondary) market or by self-tender offer. Some of the reasons companies
buyback stocks are to have it available for management stock option plans,
to have it available for the acquisition of other companies, to go private or
even to retire it.
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5. LEASING FINANCING
2. Financial Lease
This is a long-term lease that is not cancellable. It extends over most of
the estimated economic life of the asset. Should the lessee decide to
cancel the contract, then, the lessor should be reimbursed any losses.
The total payments to the lessor include costs plus interest payments.
Financial lease is also called capital or full-payout lease. In the shipping
industry, a financial lease is called bareboat charter or demise hire.
3. Full-Service Lease
In this type of lease, the lessor promises to maintain and insure the
equipment and to pay any property taxes due on it. It is also referred to
as maintenance or rental lease.
4. Net Lease
In this case the lessee agrees to maintain, insure and pay property tax
for the leased asset. Financial leases are usually net leases.
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NB: At expiration of the lease the lessee has the option, according to
contract’s specification, either to return the leased asset to the lessor, to
renew the lease at the agreed rate or, to buy the asset at its fair market
value. If the lessee fails to exercise the option, the lessor takes
possession of the asset and is entitled to any residual value associated
with it.
2. Direct Leasing
This usually involves a lease arrangement for brand new assets. The
lessee identifies the equipment, arranges for the leasing company to
buy it from the manufacturer, and signs a lease contract with the leasing
company. Major types of lessor in this case are manufacturers, finance
companies, banks, independent leasing companies and partnerships.
3. Leveraged Leasing
It is a lease arrangement in which the lessor provide part of the
purchase price (usually 20-40%) of the leased asset and borrows the
rest from the third part using the lease contract as security for the loan.
Leveraged leasing is mainly used in financing large assets like aircraft,
oilrigs and railway equipment.
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d) Tax Shields
The lessor deducts the asset’s depreciation from taxable income. If
such depreciation tax shields are put into a better use than an asset’s
user can, the benefit can be passed on to the lessee in the form of low
lease payments.
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AMT, therefore, trap companies that shield too much income; hence
AMT must be aid whenever it is higher than their tax computed in the
regular way. Using AMT, part of the benefits of accelerated depreciation
and other tax reducing items are added back hence increasing total tax
to be paid. However, lease payments are not on the list of items added
back in calculating AMT. Thus, if you lease rather than buy, tax
depreciation is less and the AMT is less.
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• The lease agreement transfers ownership to the lessee before the lease
expires.
• The lessee can purchase the asset for a bargain (fair market value)
price when the lease expires.
• The lease lasts for at least 75% of the asset’s estimated economic life.
• The present value of the lease payments is at least 90% of the asset’s
value.
Thus all other leases are operating leases as far as the above is
concerned.
Example
The company has decided to acquire a piece of equipment valued at
$148,000 to be used in the fabrication of microprocessors. If financed with
lease the manufacture will provide such financing over seven years. The
terms of the lease call for an annual payment of $27,500. The annual
payments are made in advance, i.e. annuity due. The lease is a net lease.
Required:
a. Calculate the before-tax return to the lessor.
b. Calculate the annual lease payment if required rate of return is 11%.
Answer:
a. Use the formula:
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C0
n
[
= ∑ LCFt / (1 + k )t ]
t =0
Yr LCFt PV @ 5% PV @ 10%
NPV @ 5% = $19,081.53
NPV @ 10% = $730.33
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= 9.82%
OR
Yr LCFt PV @ 11%
0 X 1.0000
1 X 0.9009
2 X 0.8116
3 X 0.7312
4 X 0.6587
5 X 0.5935
6 X 0.5346
Total 5.2305
$148,000
⇒ X =
5.231
= $28,293.00
5.7. Present Value of a Lease Contract
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Assume the cost of borrowing is 12% and the tax rate is 40%. Thus, the
after-tax cost of borrowing is 12% x (1-40%) = 7.2%.
Answer:
This Present Value figure should then be compared with the Present Value
of cash flows under the borrowing alternative. The alternative that gives a
lower Present Value is to be chosen.
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As shown in the table below, since the P.V. of cash outflow for debt
alternative is less than that of lease financing the company should use
debt.
Thus:
1. If the asset is purchased the company is assumed to finance it with a
12% unsecured debt. Loan payments are expected to be made at the
beginning of each year.
2. A loan of $148,000 is taken up at time zero payable over 7 years at
$28,955 a year.
3. Proportion of interest depends on annual unpaid capital. Thus, annual
interest for first year is $119,045 x 0.12 = $14,285
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Year End
0 1 2 3 4 5 6 7 Total
A= Loan Payment 28,955 28,955 28,955 28,955 28,955 28,955 28,955 (15,000)
B = Bt-1 - A+C
Principal Owing 119,045 104,375 87,945 69,544 48,934 25,851 -
D = Annual
Depreciation - 24,667 24,667 24,667 24,667 24,667 24,667 - 148,000
E = (C+D)*0.40 Tax-
Shield Benefit - 15,581 14,877 14,088 13,205 12,216 11,108 (6,000)
F = A - E Cash
Outflow After Tax 28,955 13,374 14,078 14,867 15,750 16,739 17,847 (9,000)
G = F/(1.072)t P.V.
Cash Outflow 28,955 12,476 12,251 12,068 11,926 11,824 11,760 (5,532) 95,728
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Definitions:
Inventory Control
inventory needs and requirements with the need to minimize costs resulting
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There are two danger points that management usually wants to avoid i.e.
inadequate inventories which disrupt production and loss of sales and
excessive inventories introduces unnecessary carrying and obsolescence
risks.
Inventory
Advantages
Disadvantages
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(a). The system analyses the items according to their value and not
according to their importance in the production process.
(b). This sometimes creates problems e.g. an item of inventory may not
be very costly and hence it may have been put in category C but
however, the item may be very important to the production process
because of its scarcity, it requires the utmost attention of the
management.
Advantages
(a). Lower Safety Stock
(b). Fixed lot sizes may make it easier to obtain quantity discounts
(c). Individual review of items is used and this may be very desirable for
expensive items
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Disadvantages
Advantages
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Disadvantages
The perpetual system is the most elaborate and more accurate method
of inventory control.
Advantages
Ö This system provides the best control of both number of units and
dollars.
Disadvantages
Advantages
Supports internal control of inventories
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Disadvantages
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Advantages
(a). Enables you to integrate controls between the head office and
branch inventory warehouse.
(d). Centralized purchasing and ordering has the added benefit that the
company can invest in more highly trained purchasing and
inventory management people.
(e). It is also more economical to train people, plus the potential for
turnover is lower.
Disadvantages
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Ö software systems
Ö IT experts for maintenance and upgrades
7. Just-in-time (JIT)
JIT espouses that firms need only keep inventory in the right quantity at
the right time with the right quality.
An example of a Just-in-time system is the SkuFlow system, warehouse
inventory control software which allows coordination of inventory in
multiple warehouse systems via any Internet connection.
Advantages
Disadvantages
Ö Limited to specific firms. Not ideal to firms which use raw materials
with a longer lead time.
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Advantages
(a). Tracking of raw materials, finished goods, process flow and assets
(b). use barcode, RFID, and
(c). use wireless technology.
Disadvantages
(a). Need for ITC expertise which may be too expensive for small
companies.
Advantages
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(j). Automated overnight running of the POS daily sales interface with
automatic generation of the sales exceptions and daily sales
reports.
(m). Export to MS Word for any wine list using any font installed on the
computer.
(o). Reduced workload and increased due the time saving features
employed by this inventory control solution.
(p). The ability to count the physical inventory quickly and accurately
using the easy-to-use handheld barcode scanner.
(q). Eliminates tedious and continual data entry for wine list editing.
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Disadvantages
Ö software systems
Ö IT experts for maintenance and upgrades
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1. FORMS OF MERGER
Horizontal Merger
It involves the coming together of two firms in the same line of business.
Such mergers result in economies through the elimination of duplicate
facilities and offering a broader product line.
Vertical Merger
It involves companies in related lines of business. The company
acquires either forward towards the ultimate consumer or back ward
towards the source of raw materials. Economies are enjoyed in the
sense that the surviving company will have more control over its
distribution and/or purchasing.
Conglomerate Merger
Two companies in unrelated lines of business merge. This can come
about due to the desire by the company for a strategic change of
business line or simply a diversify and reduce risk.
Economic Gains
An economic gain occurs if the two firms are worth more together than
apart, i.e.
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Economies of Scale
These occur when average cost declines with increase in quantity. Cost
declines come from things like sharing central services like office
management, accounting and marketing, financial control, executive
development and top-level management. The surviving firm also gains the
market share and can even dominate the market. Companies tend to gain
through the combined use of facilities and gain through synergy.
Eliminating Inefficiencies
Some firms are inefficiently managed, with the result that profitability is
lower than it might otherwise be.
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1. Signalling Effect
Value could occur if new information is conveyed as a result of the
corporate restructuring. This usually works when there is information
asymmetry between management and common stockholders.
If management believes the share, to be undervalued then a positive
signal may occur via the restructuring announcement that causes share
price to rise.
2. Surplus Funds
Firms with surplus cash and a shortage of good investment
opportunities often turn to mergers financed by cash as a way of
redeploying their capital. Firms with excess funds and not willing to
redeploy it can also be targeted for acquisition.
3. Tax Reasons
A company coming out of bankruptcy can have lots of money in unused
tax-loss carry-forwards. Such a company can buy or merge with another
profit marking company and hence be able to utilise the carry-forwards.
6. Diversification
By merging with another firm and attaining more diversification, either
through product or market diversification, help in reducing risk of loses
to the company. Diversification can be shown using the Ansoff
(Product/Market) Grid below.
EXISTING PRODUCT
NEW PRODUCT
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Financial acquisition is not strategic in the sense that the acquired firm will
operate as an independent-stand-alone entity. A financial acquisition usually
involves cash payment to the selling shareholders financed largely by debt
(i.e. Leveraged Buyout-LBO).
Earnings Impact
In this case the acquiring firm considers the effect that the merger will have
on the earnings per share of the surviving corporation.
Example
You are given the following financial data in the case where company A is
considering the acquisition, by common stock, of company B.
Company A B
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Company A has agreed to offer $36 (i.e. 20% premium above company B’s
stock) a share to company B, to be paid in company A’s stock.
Thus company A will pay 0.5625 share for each of company B’s share.
In total company A will issue 1,125,000 (i.e. 0.5625 x 2,000,000
shares) shares to acquire 2,000,000 shares in company B (hence
acquiring company B).
Company A
Thus the merger has lead to an immediate jump in the earnings per
share for company A from $4.00 to $4.08.
Suppose company A had offered a 50% premium its EPS would have
declined to $3.90 indicating an initial dilution due to the acquisition. On
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P/E ratio in the first instance was 14.4 (i.e. $36/$2.50) and in the
second instance it was 18 compared to 16 for company A.
In general, the higher the pre-merger P/E ratio and earnings of the
acquiring company in relation to the acquired company, the greater the
increase in EPS of the surviving company. Thus, avoid acquiring
companies with high P/E ratios and high earnings.
Expected
EPS ($)
Growth with merger
12
1 2 3
4 5 Years
The greater the duration of the dilution, the less desirable the acquisition is
said to be from the standpoint of the acquiring company.
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If the market exchange ratio is 1 (one) it follows that the shares will be
exchanged on a 1:1 basis and the company being acquired finds little
enticement to accept such an exchange. The acquiring company should
offer a price in excess of the current market price per share of the company
it wishes to acquire. Ceteris-paribus, shareholders of both companies will
benefit from such a merger, as shown below.
Example
You are given the following financial information of the acquiring and the
acquired company:
The P/E ratio of the surviving company is expected to remain at its high
level of 18 after the acquisition.
The acquiring company has offered $40 for each of the shares in the
acquired company.
a) Calculate the Market Price Exchange Ratio.
Thus: E.R = 40/60 = 0.667
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$30
b) Ceteris-paribus what will be the market value per share of the acquiring
company soon after the acquisition?
Surviving Co.
It follows that companies with high P/E ratios would be able to acquire
companies with low P/E ratios and obtain an immediate increase in EPS,
despite the fact that they have offered a premium, with respect to the
market price exchange ratio, provided the P/E ratio after the merger
remains sufficiently high.
Empirical evidence has shown that share prices of the target company start
increasing in days before the announcement date whilst those of the
acquiring company remain constant or fall. Returns to shareholders of the
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Cumulative
Average
Abnormal
Return
Selling Company
0 Buying Company
_
Announcement Days
Date
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There are two hypotheses usually used as the motive to employ “shark
repellent” devices, and these are:
i. Management entrancement hypothesis, which suggests that the
devices are employed to protect management jobs and that, such
actions work to the detriment of shareholders.
ii. Shareholders’ interest hypothesis, which argues that contest for
corporate control are dysfunctional and take management’s time away
from profit making activities.
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Corporate Spin-Off
It is a form of divestiture resulting in a subsidiary or division becoming an
independent company. Unlike a sell-off, in a spin-off the business unit is not
sold for cash or securities. Shares in the new company are distributed to
the parent company’s shareholders on a pro-rata basis, after which it
operates as a completely separate company.
Equity Curve-Out
It is a public sale of stock in a subsidiary in which the parent company
usually retains the majority control. The minority interest sold through a
curve-out represents a form of equity financing. The subsidiary will have its
value realised since it will have a separate stock price and trading publicly.
This will encourage managers for that subsidiary to perform well.
Going Private
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However, going private involves high transaction costs, little liquidity to its
owners, large portion of owner’s wealth is tied up in the company, and the
company’s true value might not be realised unless it goes public.
Due to the leverage management will be forced to work hard so that nothing goes
wrong.
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